Financial Markets and InstitutionLECTURE 4 ARE FINANCIAL MARKETS EFFICIENT

Learning OutcomeAt the end of this chapter, students will be able to Understand basic reasoning behind the efficient market hypothesisDifferentiate 3 forms of EMHDiscuss the evidences in favour and against EMHDiscuss the implication of the EMH

Chapter PreviewExpectations are very important in our financial system.Expectations of returns, risk, and liquidity impact asset demandInflationary expectations impact bond pricesExpectations not only affect our understanding of markets, but also how financial institutions operate.

Chapter PreviewTo better understand expectations, we examine the efficient markets hypothesis.Framework for understanding what information is useful and what is notHowever, we need to validate the hypothesis with real market data. The results are mixed, but generally supportive of the idea.

Efficient Market HypothesisThe rate of return for any position is the sum of the capital gains (Pt+1 Pt) plus any cash payments (C):

At the start of a period, the unknown element is the future price: Pt+1. But, investors do have some expectation of that price, thus giving us an expected rate of return.

Efficient Market HypothesisThe Efficient Market Hypothesis views the expectations as equal to optimal forecasts using all available information. This implies:

Assuming the market is in equilibrium:Re = R*Put these ideas together: efficient market hypothesisRof = R*

Efficient Market HypothesisRof = R*This equation tells us that current prices in a financial market will be set so that the optimal forecast of a securitys return using all available information equals the securitys equilibrium return.

Financial economists state it more simply: A securitys price fully reflects all available information in an efficient market.

Example 6.1: The Efficient Market Hypothesis

Efficient Market Hypothesis Rationale behind hypothesisWhen an unexploited profit opportunity arises on a security (so-called because, on average, people would be earning more than they should, given the characteristics of that security), investors will rush to buy until the price rises to the point that the returns are normal again.

Rationale Behind the Hypothesis (cont.)Why efficient market hypothesis makes sense If Rof > R* Pt Rof If Rof < R* Pt Rof Until Rof = R* All unexploited profit opportunities eliminatedEfficient market condition holds even if there are uninformed, irrational participants in market

Efficient Market HypothesisFinancial markets today may have many profit-maximizing, well-informed, intelligent investorswont have profitable asset trades over timeno systematic mispricing of assets temporary deviation of actual returns from expected should be quickly eliminatedeach financial asset will generate an ordinary, normal or expected rate of return commensurate with its level of risk3-*The efficient market hypothesis states that current security prices will fully reflect all available information because in an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunity necessary for a financial market to be efficient does not require that all market participants be well informed.

Efficient Market HypothesisThere are 3 forms of EMH:Weak form Semi-strong Strong

1. Weak Form EfficiencyCurrent price of a financial asset already reflects all its historical price and trading volume.This implies that past rates of return and other market data should have no relationship with future rates of return.

3-*

2. Semi-strong Form of EfficiencyCurrent price of a financial asset already reflects all publicly available and relevant information.This information could be fundamental data, management quality, earnings forecasts and etc.This implies that decisions made on new information after it is public should not lead to above-average risk-adjusted profits from those transactions

3. Form of Efficiency Argues that the current price of a financial asset already captures all relevant public and private information.This implies that even insiders also unable to earn an abnormal return.

Evidence on Efficient Market HypothesisFavorable EvidenceInvestment analysts and mutual funds don't beat the marketStock prices reflect publicly available info: anticipated announcements don't affect stock priceStock prices and exchange rates close to random walk; if predictions of DP big, Rof > R* predictions of DP smallTechnical analysis does not outperform market

Evidence in Favor of Market EfficiencyPerformance of Investment Analysts and Mutual Funds should not be able to consistently beat the marketThe Investment Dartboard often beats investment managers.Mutual funds not only do not outperform the market on average, but when they are separated into groups according to whether they had the highest or lowest profits in a chosen period, the mutual funds that did well in the first period do not beat the market in the second period.

Evidence in Favor of Market EfficiencyDo Stock Prices Reflect Publicly Available Information as the EMH predicts they will?Semi-strong form: a positive announcement about a company will not, on average, raise the price of its stock because this information is already reflected in the stock price.favorable earnings announcements or announcements of stock splits, do not, on average, cause stock prices to rise.

Evidence in Favor of Market EfficiencyRandom-Walk Behavior of Stock Prices that is, future changes in stock prices should, for all practical purposes, be unpredictableIf stock is predicted to rise, people will buy to equilibrium level; if stock is predicted to fall, people will sell to equilibrium level (both in concern with EMH)Thus, if stock prices were predictable, thereby causing the above behavior, price changes would be near zero, which has not been the case historically

Evidence in Favor of Market EfficiencyTechnical Analysis means to study past stock price data and search for patterns such as trends and regular cycles, suggesting rules for when to buy and sell stocksThe weak form EMH suggests that technical analysis is a waste of time.The simplest way to understand why is to use the random-walk result that holds that past stock price data cannot help predict changesTherefore, technical analysis, which relies on such data to produce its forecasts, cannot successfully predict changes in stock prices

Evidence on Efficient Market HypothesisUnfavorable EvidenceSmall-firm effect: small firms have abnormally high returnsJanuary effect: high returns in JanuaryMarket overreactionExcessive volatilityMean reversionNew information is not always immediately incorporated into stock prices

Evidence Against Market EfficiencyThe Small-Firm Effect is an anomaly. Many empirical studies have shown that small firms have earned abnormally high returns over long periods of time, even when the greater risk for these firms has been considered.The small-firm effect seems to have diminished in recent years but is still a challenge to the theory of efficient marketsthe small-firm effect may be due to rebalancing of portfolios by institutional investors, tax issues, low liquidity of small-firm stocks, or an inappropriate measurement of risk for small-firm stocks

Evidence Against Market EfficiencyThe January Effect stock prices to experience an abnormal positive return in the month of January that is predictable and, hence, inconsistent with random-walk behavior.

Evidence Against Market EfficiencyTheory explain the January EffectTax-loss selling: sell stocks before the end of the year in December because they can then take capital losses on their tax return and reduce their tax liability. Then when the new year starts in January, they can repurchase the stocks, driving up their prices and producing abnormally high returns.Window dressing: Sell losing stocks before a period ends in order to avoid revealing that they have held poorly performing stock.

Evidence Against Market EfficiencyMarket Overreaction: recent research suggests that stock prices may overreact to news announcements and that the pricing errors are corrected only slowlyWhen corporations announce a major change in earnings, say, a large decline, the stock price may overshoot, and after an initial large decline, it may rise back to more normal levels over a period of several weeks.This violates the EMH because an investor could earn abnormally high returns, on average, by buying a stock immediately after a poor earnings announcement and then selling it after a couple of weeks when it has risen back to normal levels.

Evidence Against Market EfficiencyExcessive Volatility: the stock market appears to display excessive volatility; that is, fluctuations in stock prices may be much greater than is warranted by fluctuations in their fundamental value.Researchers have found that fluctuations in the S&P 500 stock index could not be justified by the subsequent fluctuations in the dividends of the stocks making up this index.Other research finds that there are smaller fluctuations in stock prices when stock markets are closed, which has produced a consensus that stock market prices appear to be driven by factors other than fundamentals.

Evidence Against Market EfficiencyMean Reversion: Some researchers have found that stocks with low returns today tend to have high returns in the future, and vice versa.Hence stocks that have done poorly in the past are more likely to do well in the future because mean reversion indicates that there will be a predictable positive change in the future price, suggesting that stock prices are not a random walk.Newer data is less conclusive; nevertheless, mean reversion remains controversial.

Evidence Against Market EfficiencyNew Information Is Not Always Immediately Incorporated into Stock PricesAlthough generally true, recent evidence suggests that, inconsistent with the efficient market hypothesis, stock prices do not instantaneously adjust to profit announcements.Instead, on average stock prices continue to rise for some time after the announcement of unexpectedly high profits, and they continue to fall after surprisingly low profit announcements.

Implications of the EMHActive versus Passive Portfolio ManagementPassive investment strategyBuying well-diversified portfolio without attempting to find mispriced securitiesIndex fundMutual fund which holds shares in proportion to market index representation

Implications of the EMHRole of Portfolio Management in Efficient MarketActive management assumes market inefficiencyPassive management consistent with semi-strong efficiencyInefficient market pricing leads to inefficient resource allocation

ReferencesMishkin & Eakins. 2012. Financial Markets and Institutions, 7th ed. Pearson.Bodie, Z., Kane, A., Marcus, A. J. (2013) Essentials of Investments 9th Edition, McGraw-Hill.

Tutorial 4Mishkin & Eakins. 2012. Financial Markets and Institutions, 7th ed. Pearson.- Pg. 172 & 173 Questions 1, 4, 5, 10, 11, 12

Why some changes of the stock price are unpredicted?Why the hot tips from brokers are not reliable?

- These depends on the useful information (different version of EMH involve different useful information). *Expected return will head toward the equilibrium return, hence R(e) = R (of).

**In an efficient market, investors cannot expect to earn an abnormally high return (greater than equilibrium return). *The ability to predict prices would indicate that all available information was not already reflected in stock prices.

*Even in an efficient market, calls for the selection of a well-diversified portfolio is needed. *